(FORTUNE Small Business) -
Life should not be so frustrating for small-business owners who want to offer health insurance to their workers. While big corporations can choose among eager insurers, a small-business owner may be lucky if she can persuade even two insurers to bid for her business. For the same price, she will probably face higher deductibles, co-payments, and administrative costs. If even one of her employees gets seriously ill, her rates are probably going to spike.

But if she doesn't offer insurance - and currently only 59% do, compared with 98% of big businesses - her workers who buy their own will lose out on a hefty tax break. Job-based health insurance isn't subject to income or payroll taxes, but individually purchased insurance is. And her best workers might move to companies with better benefits. That's what happened to Ruby Mason, the CEO of Four Corners Mortgage in Scottsdale, whose sister left to work for a rival corporate bank where health-care premiums were a fraction of the $700 a month she had been paying. "It made me angry," Mason says. "She might not have talked to the bank at all had health benefits not been an issue."

President Bush is aware of the problem. He vowed in his State of the Union address to make sure that "individuals and small-business employees can buy insurance with the same advantages that people working for big businesses now get." His proposed solution: Let consumers contribute more to tax-free health savings accounts and deduct their premiums if they have HSA policies. To which Robert Moffit replies, "He didn't go far enough."

Moffit is a health-care expert at the conservative Heritage Foundation, which favors a bolder proposal: Offer everyone the same tax break for health insurance that employees receive. "If you're going to provide a level playing field," he asks, "why not provide the tax break for everyone?"

Moffit's question raises a bigger one: Why don't we do away with the employer-sponsored model altogether and give financial assistance directly to individuals to buy health insurance on their own? This would entail a radical overhaul of the health-care system.

But there is nothing sacrosanct about employer-provided health insurance. Corporations only began offering the benefit during World War II as a way to entice workers with compensation that wasn't subject to wartime wage controls. Gary Claxton, health-care expert for the Kaiser Family Foundation, a nonpartisan health-care think tank, says that entrepreneurs would benefit from rethinking this arrangement. "Small businesses would be better off if we disconnected the tax break," he says, "because then they'd be competing equally for workers based on wages."

Even if small businesses try to compete by offering higher salaries so employees can buy health insurance on their own, they are still at a disadvantage thanks to the tax break employees get on their health benefits. For instance: An employee who earns $40,000 a year and receives a $10,000 family policy from his employer is essentially paid $50,000--$10,000 of it tax-free. But one who is paid a $50,000 salary and purchases his own policy will owe about $1,330 more in income and payroll taxes, based on his higher taxable income. The small business must pay payroll taxes on this amount as well, a penalty of $765. Eliminating the tax break for job-based insurance would remove this inequity.

And there would be other advantages. In 2006 the tax break for employer-provided health insurance will cost the federal government $126 billion, with much of that money going to plans that offer employees little incentive to consume health care in a cost-efficient manner. If the tax break were instead directed to individuals, says David Cutler, an economics professor at Harvard University, the U.S. could probably afford to provide coverage to the 45 million Americans who lack insurance now.

Breaking the link between employment and insurance poses some risks. The individual health insurance market today lacks the protections of the group market, which ensures that older and sicker workers can buy decent coverage. Legislation would be required to set coverage, access, and premium rules, and to create insurance pools. These pools would help keep rates affordable, stable, and equitable, because large groups can negotiate better prices. Such a system would also mandate that individuals buy health insurance to spread the costs of caring for the neediest. (At press time Massachusetts governor Mitt Romney was considering signing a landmark bill that had passed the state legislature, requiring residents to buy insurance and fining any business with more than ten employees as much as $295 per worker if it does not provide it.)

Many powerful interest groups, from union members to corporate managers and insurance companies, benefit from the status quo and will probably fight any effort to change it. Still, with the health-care crisis deepening, some experts believe a consensus is building for thoroughgoing reform. The National Small Business Association (nsba.biz), an advocacy organization, has proposed a plan to offer individuals who buy health insurance the same tax breaks as workers who buy through their employers. "No stakeholder is satisfied with the current system, and businesses don't want to buy health insurance anymore," says Regina Herzlinger, a professor and health-care expert at Harvard Business School. "It's going to happen sooner rather than later."

There is a state-supported option for small-business health insurance coverage. Find out more.

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